Opportunities in Oil and Gas Stocks

An outlook and overview of the US oil and gas industry from an investor's perspective.

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Crude Oil

Persisting worries about Europe's sovereign debt crisis crippling the continent's economy, high US crude stocks and worries about China's growth outlook have been weighing on investor sentiment, weakening oil prices to seven-month low of around $90 per barrel. Partly offsetting this unfavorable view has been a tightening global supply picture in view of the geopolitical fallout over Iran's alleged nuclear ambitions and strong demand from developing countries.

As such, crude oil's near-term fundamentals remain mixed, to say the least. The long-term outlook for oil, however, remains favorable given the commodity's constrained supply picture. In particular, while the Western economies exhibit sluggish growth prospects, global oil consumption is expected to get a boost from continued strength in the major emerging powers like India and Brazil that continue to grow at a healthy rate.

According to the Energy Information Administration, or EIA, which provides official energy statistics from the US Government, world crude consumption grew by an estimated 0.8 million barrel per day in 2011 to a record-high level of 87.9 million barrels per day. In 2010, oil demand increased by over two million barrels per day to 87.1 million barrels per day, which more than made up for the losses of the previous two years, and surpassed the 2007 level of 86.3 million barrels per day (reached prior to the economic downturn).

One might note that global demand for 2009 was below the 2008 level, which itself was below the 2007 level – the first time since the early 1980's of two back-to-back negative growth years.

The agency, in its most recent Short-Term Energy Outlook, said that it expects global oil demand growth of 1.0 million barrels per day in 2012 and 1.2 million barrels per day in 2013. EIA's latest forecasts assumes that demand will decline in North America and Europe but this will be more than made up by impressive consumption surge coming from China, the Middle East, Central and South America.

Separately, the Organization of the Petroleum Exporting Countries (OPEC) -- which supplies around 40% of the world's crude -- predicts that global oil demand would increase by 0.9 million barrels per day annually, reaching 88.7 million barrels per day in 2012 from last year's 87.8 million barrels per day.

Lastly, the third major energy consultative body, the Paris-based International Energy Agency (or IEA), the energy-monitoring body of 28 industrialized countries, said that it expects world oil consumption to grow by 0.8 million barrels per day in 2012 to 90.0 million barrels per day.

In our view, crude oil prices in 2012 are likely to witness more upside -- rather than downside -- given the considerable supply tightness in the market. While domestic demand is relatively soft and the global economy still showing signs of weakness, the fact that demand is outpacing supply appears to be evident.

As long as growth from the developing nations continues and the global output is unable to keep up with that, we are likely to experience a surge in the price of a barrel of oil. With a world population of seven billion people and all the easy oil being already discovered and expended, our firm assumes that crude will trade in the $90-$100 per barrel range for the near future.

Natural Gas

Over the last few years, a quiet revolution has been reshaping the energy business in the US. Known as "shale gas" -- natural gas trapped within dense sedimentary rock formations or shale formations -- it is being seen as a game-changer, set to usher in an era of energy independence for the country. The success of this unconventional fuel source has transformed domestic energy supply, with a potentially inexpensive and abundant new source of fuel for the world's largest energy consumer.

With the advent of hydraulic fracturing (or fracking) -- a method used to extract natural gas by blasting underground rock formations with a mixture of water, sand and chemicals -- shale gas production is now booming in the US. Coupled with sophisticated horizontal drilling equipment that can drill and extract gas from shale formations, the new technology is being hailed as a breakthrough in US energy supplies, playing a key role in boosting domestic natural gas reserves.

As a result, once faced with a looming deficit, natural gas is now available in abundance. In fact, gas stocks -- currently some 40% above the benchmark five-year average levels -- are at their highest level for this time of the year, reflecting low demand amid robust onshore output.

Due to this huge natural gas surplus, inventories in underground storage started to climb since March – weeks earlier than the usual summer stock-building season of April through October. They have persistently exceeded the five-year average since late September last year and are likely to test the nation's underground storage facilities by fall. In fact, the EIA foresees natural gas storage at record highs of 4.10 trillion cubic feet by October.

Natural gas prices have dropped approximately 49% from 2011 peak of $4.92 per million Btu (MMBtu) in June to the current level of around $2.50 (referring to spot prices at Henry Hub, the benchmark supply point in Louisiana). Incidentally, prices hit a 10-year low of $1.82 during late April.

To make matters worse, near-record mild weather across most of the country curbed natural gas demand for heating all winter, leading to an early beginning for the stock-building season. The grossly oversupplied market continues to pressure commodity prices in the backdrop of sustained strong production.

This has forced several natural gas players to announce drilling/volume curtailments. Exploration and production firms like Ultra Petroleum Corp. (UPL), Talisman Energy Inc. (TLM), and Encana Corp. (ECA) have all reduced their 2012 capital budget to minimize investments in development drilling.

On the other hand, Oklahoma-based Chesapeake Energy Corp. (CHK) -- the second-largest US producer of natural gas behind ExxonMobil Corp. (XOM) -- and rival explorer ConocoPhillips (COP) have opted for production shut-ins to cope with the weak environment for natural gas that is likely to prevail during the year.

However, we feel these planned reductions will not be enough to balance out the massive natural gas supply/demand disparity, and therefore we do not expect much upside in gas prices in the near term. In other words, there appears no reason to believe that the supply overhang will subside and natural gas will be out of the dumps in 2012.

Opportunities

In this current turbulent market environment, we advocate the relatively low-risk energy conglomerate business structures of the large-cap integrateds, with their fortress-like balance sheets, ample free cash flows even in a low oil price environment and growing dividends. Our preferred name in this group remains Chevron Corp. (CVX).

Its current oil and gas development project pipeline is among the best in the industry, boasting large, multiyear projects. Additionally, Chevron possesses one of the healthiest balance sheets among peers, which helps it to capitalize on investment opportunities with the option to make strategic acquisitions.

Within the oilfield services group, we like Core Laboratories NV (CLB). We are a fan of Core Labs' leadership position in the reservoir optimization niche, along with its global footprint and deep portfolio of proprietary products and services. Furthermore, the company's low asset intensive operations and limited capex needs allow it to generate substantial free cash flows.

Buoyed by the favorable trends in the refining sector, we are more optimistic on the industry than we were 12 months ago. An uptick in economic activity overseas (mainly in developing countries) and prospects for higher fuel demand in the U.S. are likely to push 2012 industry margins higher than last year's levels. Against this backdrop, we are particularly bullish on Marathon Petroleum Corp. (MPC) and Western Refining Inc. (WNR).

Denbury Resources Inc. (DNR), a leading CO2 "Enhanced Oil Recovery" (EOR)-focused company targeting a large attractive market, is also a top pick. With its unique profile, compelling economics and an unmatched infrastructure, Denbury is nicely positioned to deliver long-term sustainable growth. Additional positives for Denbury include a strong financial position, low-risk investments and an active divestment policy.

Canada's biggest energy firm and the largest oil sands outfit Suncor Energy Inc. (SU) is also worth a look. We like the company's impressive portfolio of growth opportunities, unique asset base and high return potential in the long run. Suncor has significant oil sands and conventional production platform, huge long-lived oil-sands reserves and a robust downstream portfolio.

The company's asset base includes substantial conventional reserves and production at offshore Eastern Canada and in the North Sea , which generate strong margins and should provide free cash flow to fund future oil sands expansion.

Finally, despite the depressing natural gas fundamentals and the understandable reluctance on the investors' part to dip their feet into these stocks, we would advocate to opt for EOG Resources Inc. (EOG), a former natural gas exploration and production (E&P) company that has made significant headway into the more profitable oil space with the introduction of the commercial viability of shale oil.

WEAKNESSES

We are bearish on Brazil's state-run energy giant Petroleo Brasileiro SA (PBR), or Petrobras SA. Though the company stands to benefit from Brazil's economic growth and huge pre-salt oil reserves, we are concerned by investor skepticism regarding Petrobras' huge investment requirements, as well as the possibility of heightened state interference and earnings dilution following the $70 billion share sale. As such, we see little reason for investors to own the stock.

We are also skeptical on onshore contract driller Patterson-UTI Energy Inc. (PTEN). In particular, we remain wary of increased labor costs for contract drilling that may lead to slower margin growth going forward. Lastly, Patterson-UTI is faced with weak natural gas fundamentals, which are expected to further limit its ability to generate positive earnings surprises.

Engineering and construction firm McDermott International (MDR) is another company we would like to avoid for the time being, mainly due to the tentative commodity price scenario and the company's clouded post-split outlook.

Near-term bookings remain lumpy at McDermott, as the current uncertain environment has adversely affected the economics of building new oil and gas infrastructure. Steep operating costs and the Texas-based engineering-to-project management service provider's inability to shake off the slower award environment in 2011 are also behind our bearish investment theme.

Further, we remain cautious about natural gas-focused energy firm Questar Corporation (STR). The expected bearish natural gas fundamentals over the next few quarters and excessive domestic gas supplies are likely to restrict near-term growth prospects at Questar Pipeline. We also believe that upside potential will remain limited until the company has fully reaped the benefits of the spin-off of its unregulated E&P business.

We also recommend avoiding ConocoPhillips, one of the six supermajor oil companies. Following the recent spin-off of its refining/sales business into a separate, independent and publicly traded company Phillips 66 (PSX), ConocoPhillips is now totally dependent on its upstream portfolio that offers lackluster volume growth prospects. Moreover, the transfer of the downstream operations (post-split) has left the Houston, Texas-based firm with a less diversified business.

Lastly, we expect shares of independent gas-focused exploration and production firms such as Forest Oil Corp. (FST), Southwestern Energy Co. (SWN), etc. to be under pressure in the near future. The companies' high natural gas exposure raises their sensitivity to gas price fluctuations, compared to the more-diversified independent peers with a balanced oil/gas production profile. Continued low natural gas prices have created a difficult operating environment for the firms.

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